Tuesday, December 13, 2005

Debt and interest rates

When interest rates are low (too low?) what is the rational way to take advantage of that (mis)pricing? In this note on JaneGalt, I argued that governments should run deficits in times of subsidized lending.

But what should households do? This excellent post by Calculated Risk details what households *have* done:

It appears households initially took on debt and kept their payments steady as interest rates dropped. However, recently the portion of disposable personal income dedicated to debt service has risen steadily. As interest rates rise, and with the new credit card minimum payments, the DSR and FOR will probably continue to rise, putting more pressure on household finances.

As debt got cheaper, individuals took on more and overall payments stayed the same. However, it seems that people are now allocating more of their household income to debt servicing.

One might expect that, as debt gets cheaper, households would buy what they bought before and pocket the saves (reducing the % they spend on debt servicing overall). What seems to have happened is that people took the savings from lower interest rates and spent it competing up the price of housing. But now they seem to be just plain-ole spending more on housing as both mortgage financial obligations and household debt overall rise in lockstep.

This, I might add, is a stupid action to take in the face of low rates. Moving consumption forward is sensible (and hard to do) but just consuming more, or consuming overprices assets, is dumb.

And on the subject of dumb, this article on Slate is really bogus, btw. It argues that mortgage lenders are afraid to foreclose on delinquent homeowners because it's onerous.

If it's onerous today it's been just as onerous in the past, so this is not a credible reason for housing lenders to be soft on deilnquency. It concludes

All of which means the housing boom is being fueled by the willingness of lenders to let borrowers get behind—and stay behind—on their payments. Homeowners go deeper and deeper in debt and become less and less home "owners," but they get to keep the roof over their heads. It used to be that only gigantic banks and corporations like Citigroup and Chrysler were regarded as too big to fail. Today, the humble homeowner enjoys that status as well.

This is additionally bogus. Firstly, there is nothing mystical about someone becoming less and less a home "owner" and getting a roof over their head -- it's called renting. Secondly, a shift in financing to ignore the principle and focus on financing means that banks are moving from being financiers to being landlords, and therefore being extremely exposed to the price of real estate.

When prices fall and become a drag on lenders balance sheets, they will work hard to get them off. To date, housing has not fallen in real or nominal terms, nor have rates moves that much, so home default rates remain low.